There was an interesting exchange on Minyanville today about the Activist Fed. The origin was a set of reader questions about subprime bailouts, the Fed’s role in the process, and thoughts from Pimco about the real estate (credit) lending excesses that will bear on the economy for years to come.
- What do you think the probability is that an activist Fed will seek to spread the consequences over a significantly longer time period?
- Do we really have a much more “activist” Fed, or am I reading too much between the lines?
- If some of what I’ve hypothesized is really possible, what are some not broadly considered potential ramifications that I should be thinking about for the markets and the economy?
The answers to those interesting questions can be found in Minyan Mailbag: The “Activist” Fed. Here is a synopsis:
If the Fed had the ability, they would of course insulate the banking system and markets from the pain of this credit write down for as long as they could – by spreading it out over time. On that there is no debate.
The real debate is whether or not the Fed can do that. After all, the Fed itself can monetize anything and keep rates low (at the expense of the currency), but the only thing that matters really is will the market want the credit? The more debt there is, the more income is needed to service that credit, the less effective the Fed is in cajoling the market into taking it. That is, the bankers become less inclined to lend and borrowers become less able to borrow.
In Japan from 1990 to 2003, the BOJ kept rates at virtually zero but during that entire time the Japanese consumer and corporation did not want to borrow (having suffered asset price write downs and thus hits to their capital bases) and the Japanese banks themselves did not want to lend (having themselves suffered the same capital write-downs from their holdings (direct on their balance sheets and indirect via loans to consumers/corporations). Thus what the BOJ wanted was moot – they wanted to shield the Japanese banking system from the negative effects of the property and stock busts but were unable to at all. Huge debt levels create the circumstances above: where consumers and corporations cannot suffer even small capital declines (stock or property) before their appetite for credit diminishes massively.
The fact that total US bank lending y/y is now about 8% y/y vs. 13.5% or so as early as last summer (growth rate is coming down pretty rapidly) speaks to this idea: the US is already seeing declines in total bank lending that have in 1990, 1996, and 2000 led to credit cycle ‘busts’ of some degree. And obviously the amount of debt outstanding now dwarfs all of those periods; so a decline in the willingness of bankers to lend (and thus support the ability of debtors to service their debts and simultaneously support debtor’s capital bases) bodes ill indeed for the US’ debt laden consumer economy.
Most of the LBO deals we have seen will eventually suffer greatly because of leverage: one little problem in margins will cause a catastrophe to earnings. This is what leverage does. The more levered a company is the more stable its margins must be.
Given the massive amounts of credit that are now being created outside of the traditionally controlled “Fed channels” (Stephanie Pomboy puts the number at 75% of total credit creation), one must ask the additional question of if the Fed can impact marginal credit demand (by lowering its price or monetizing it outright). Recall that while the Fed was increasing rates 17 times in 2004/05, the housing bubble – and the ‘creative’ financing that fed it – was reaching manic proportions. Thus, from that experience, you could conclude that the Fed is less in control of credit supply (and as well credit demand) as they would like to admit.
Who is in control? The People’s Bank of China, the Bank of Japan, pension and hedge funds, and the broader capital markets: all have a stake in keeping the liquidity cycle going (and thus the credit creation cycle cycling). But those are fickle friends: the Olympics, the carry trade, the aging of the G7 populations, and the 2%/20% model of hedge funds are feeding the frenzy now but any one of those factors could change and cause any of those factors to turn tail and end the game of musical chairs, causing the deflationary credit bust we think is an inevitability with a system as heavily indebted as the US’.
From the Fed’s own flow of funds we see just how ineffective the Fed has become: in 1980 it took $1 of new debt to create $1 of GDP (debt levels were much lower and capital usage was much tighter so new credit found its way into production), whereas today it takes $7 to $8 of new debt to create $1 of GDP.
No matter what the Fed ‘wants,’ no matter what they are able to get FNM, FRE, BAC, WM, C and the gang to do, and no matter who (PBOC, BOJ, TIAA-CREF, or PIMCO) gets the last chair, there is one verity in macroeconomics:
All credit cycles cycle.
John Succo and Scott Reamer
Minyan Mailbag Key Ideas
- The Fed’s wants and the Fed’s ability are two different things
- 75% of credit creation is now outside the Fed’s control
- Inability to service debt is the limiting factor
- With leverage small problems in margins can be catastrophic to earnings
- 1980 it took $1 of new debt to create $1 of GDP. Today it takes $7 to $8 of new debt to create $1 of GDP.
- All credit cycles cycle
Following are a few thoughts of my own on the progression of the Credit Cycle
Progression of Debt Problems
- Rising delinquencies
- Rising foreclosures
- Rising bankruptcies
Today’s delinquencies become tomorrow’s foreclosures and bankruptcies. All three are soaring now. 2.1 million people missed a mortgage payment in 2006. But unemployment rates are at historic lows with only one way to go. Rising unemployment will compound the already huge problems by orders of magnitude. Rising unemployment is likely to be the key factor that pushes the mess from subprime to prime.
Yes, the Fed is trying to stop this progression. So is Wa-Mu and so is Freddie Mac. But the intervention is doomed to failure as I pointed out in The Fatal Flaw in Housing Bailout Plans.
The flaw is these programs are all designed to keep people in their homes regardless of the value of those homes. Who wants to be “bailed out” if it means owing $350,000 on a mortgage when their house is only worth $175,000?
I started to write “The longer the Fed and global central bankers try and prevent the cycle from cycling, the bigger the disaster when they finally lose control” but that’s not quite correct.
Professors Succo and Stephanie Pomboy have already shown the Fed is no longer in control. I have talked about that idea before as well and so have others like John Hussman (See Independent Thought and Superstition and the Fed). The only question then is not about what will happen but rather how feverish the speculation gets before the whole mess implodes and of course the timing of that implosion.
Check it out. It’s another good one.
Mike Shedlock / Mish/